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What Defines a Partner?

Worth Magazine, December 2012 - January 2013

By Michael Kosnitzky, Boies, Schiller & Flexner LLP

BEING RECOGNIZED AS A PARTNER FOR TAX PURPOSES HAS HUGE FINANCIAL ADVANTAGES BUT THE COURTS AND THE IRS HAVE VERY SPECIFIC THOUGHTS ON THE MATTER. 

Being recognized as a partner for tax purposes is a little like recognizing pornography: To paraphrase Supreme Court Justice Potter Stewart, you’ll know one when you see one. Partner classification can be extremely important in the taxation of numerous business and investment transactions.  For example, only a partner in a partnership can enjoy the flow-through of deductible losses and tax credits from a partnership, as well as the flow-through of profits that may be taxed at favorable long-term capital gains rates (at the moment, 15 percent).  The same benefits accrue to so-called members in domestic limited liability companies, who are generally treated as partners in a partnership for tax purposes because limited liability companies themselves are generally treated as partnerships for tax purposes. 

But simply calling someone a partner, or describing someone as a partner in a document, doesn’t make him one for tax purposes; the IRS is certainly not bound by any such label. Even if a person is legally a partner or member under state law, that status doesn’t automatically translate into partner status for tax purposes. The IRS and the courts have their own criteria. 

The primary question that the IRS and the courts look at is the alleged partner’s potential to sustain a loss or earn a profit from the partnership’s entrepreneurial activity. For example, a “partner” who does not receive an allocation of losses or deductions and receives only a percentage of gross income would probably not be considered a partner for tax purposes.  Instead, the IRS would likely consider him a manager or independent contractor.  Likewise, someone who makes a capital contribution to a partnership in exchange for, say, a 9 percent return and nothing more would also probably not be considered a partner for tax purposes, but as a subordinated lender to the partnership. 

The law surrounding tax status as a partner is changing. In August, the Third Circuit Court of Appeals ruled in a case called Historic Boardwalk Hall v. Commissioner that a partner—in this case, Pitney Bowes—was not a bona fide partner for federal income tax purposes and, therefore, was not entitled to receive the flow-through benefit of certain historic rehabilitation tax credits. The court noted that Pitney Bowes could not be considered a partner for tax purposes because it had no meaningful entrepreneurial risk in the business. Instead, Pitney Bowes was assured of receiving tax benefits or indemnity payments equal to the capital it committed to the venture. And the company not only had limited potential for loss, it had limited potential for profit; it was a “preferred” partner and, because of various option agreements, was highly unlikely to receive more than a 3 percent preferred return on its invested capital. 

The Historic Boardwalk Hall case has significant implications for the structuring of future preferred-partnership arrangements, which are commonly used in estate planning and other tax and business strategies. Notably, so called “freeze” transactions, in which an owner of a business exchanges his ownership in its assets or his common partnership or membership interests for preferred partnership or membership interests paying a fixed coupon return but with little upside potential or downside risk, will need to be closely evaluated. Being a partner has its benefits; thinking you’re a partner when the IRS disagrees can be costly.